FICO: Is Your’s Fabulous or Fading?

We all have credit and most of us use it daily. It has become ubiquitous in our society, but most users don’t fully understand how it is created and how it is best maintained.

Credit supports the foundation of our economy. The upheaval that we all lived through in 2008 was the unraveling of credit. Most people don’t realize that the credit markets are many times larger than the stock markets. Typically, we see stock market corrections every few years, but corrections in the credit markets are rare, more serious, and take much longer to repair. Healthy credit markets are important to us all.

Establishing and maintaining good credit is essential to creating and protecting your wealth. The process of consistently improving your credit or maintaining it at a superior level is one of the best financial disciplines you can develop. It requires balancing expenses with income and reward with risk.

Our largest purchases are typically made using credit. Your credit history will largely determine whether you qualify for a loan and what interest rate you will pay. Your credit history has two main components, the credit report and the credit score.

Your Credit Report

Your credit reports are created by the three main credit bureaus: Equifax, Experian, and TransUnion. Each credit bureau receives information about most of your credit uses. Generally, they have similar information, but there may be some lenders that report to just one or two of the bureaus. Since your FICO score is calculated using the data on your credit reports, in reality, you actually have three FICO scores – each one based on the reported information from one credit bureau.

Recent surveys show that nearly 80% of credit reports contain an error, and almost 30% contain a serious error. It is very important that your credit reports do not contain any errors that will damage your credit history, and errors will likely stay on your report until you fix them. To verify the accuracy of your reports you must obtain all three reports and carefully examine each one. Challenge any errors you find, first through the credit bureau and, if unsuccessful, through the lender. This often takes some hard work, but it is worth the battle.

Your Credit Score

It is critical to know how your score is calculated, how it is used by lenders, and how you can improve it. Your credit score (also known as your FICO score since it was developed by the Fair Isaac Corporation) is a number between 300 and 850. This number (higher is better) quantifies your credit risk to lenders. It is generally used along with a few other pieces of information, such as income and age, to determine the interest rate on a loan. A 100-point difference in your FICO can cost you $10,000 in interest per $100,000 of mortgage or $1,000 in interest per $10,000 of car loan over the lifetime of the loan.

Your goal is to get your credit score into the highest level, 760-850. Rumor has it that a 761 is just as good as an 849, so don’t go overboard trying to max it out. Fair Isaac Corporation sorts the information on your credit report into 5 categories with varying weights to calculate your score (see table). Hopefully, most of the work you’ll need to put into raising you score will likely be focused on debts other than your mortgage and car loans. Revolving debts such as credit cards and lines of credit are where most people, with a little management, can improve their FICO score. They are called revolving debts because you can run them up and then pay them down repeatedly.

Weightings	Factors
35% - Payments	Do you always pay on time?
30% - Balances	How much do you owe? - Utilization rate in total and by account
15% - Duration	How long have you had credit? - Longer is better
10% - Applications	Do you maintain accounts for a long time? - Older accounts are better
10% - Mix	What is the mixture of credit sources? - More are better

Your payment history counts for 35% of your score, so paying on time – all the time – really matters the most. Credit duration counts for 15% of your score, so the longer you have had credit the better. Thus, it can be a good idea to help your child establish credit as soon as they turn 18, and then teach them to manage it effectively. Your credit mix weighs in at 10% of your score. Your FICO score improves as you responsibly take on varying types of debt, such as car loans, lines of credit, and mortgages. The remaining two categories are more complicated, require some ongoing management, and will be the areas where most people can improve their FICO scores.

Your balances count for 30% of your score, and you must manage both your total credit lines and your “utilization rate.” First, your total credit lines must be reasonable, so be very discerning about the credit offers you accept. Generally, your credit card lines should not be more than 2-3 months of your gross salary. Second, your utilization rate is the amount of credit you’re using versus your total credit – in other words, your current balance divided by your credit line. Thus, your utilization rate is 25% with a credit card approved for $40,000 carrying a $10,000 balance. Lenders want to see a utilization rate below 50% on each card and in total. Thus, even though you might save money by transferring several balances onto one lower interest rate card, your FICO score will go down if your utilization rate on that new card is over 50%.

Last, but not least, credit applications impact 10% of your score. First, it is a good idea not to apply too often for credit as multiple applications or credit inquiries hitting your credit file lower your score for awhile. Second, the age of each account is also important as older credit is favorable. Thus, if you close an old card or open a new card, your FICO score will go down for awhile because the “average” age of your credit decreased. To protect your score when you no longer want a very old card, ask to decrease your credit line, but keep it open until you have had other cards open for many years.

Conclusion

For many families, this recession has caused some real belt tightening, or at least more thought is being given to debt than ever before. These adjustments can be painful, but they are healthier in the long-run for each of us and for our economy. While it has always been important to maintain the right amount of good credit, Americans are now more aware of what can happen when too much bad credit meets a serious recession. A healthy FICO score safeguards your wealth by protecting your available credit during recessions and improves your wealth by allowing you to access better loans in any environment. A few hours a year goes a long way to saving you money and protecting your wealth.

Helpful Sources

Obtain your credit score at myfico.com

Get a free annual credit report at annualcreditreport.com

Stop junk mail credit card offers at optoutscreen.com

Research competitive credit offers at bankrate.com

Compare your credit cards at mint.com

Analyze your credit score at creditkarma.com

Find help with credit problems at nfcc.org

For a Fabulous FICO

Pay on time

Keep utilization rates under 50%

Pay off monthly, if possible

Establish credit at age 18

Apply for new credit infrequently

Don’t close old accounts too often

Open varying types of credit over time

Get all 3 credit reports & correct errors

MARKET UPDATE -- Winter 2010

We would like to tell you everything is fine and there’s nothing to worry about. However, we must accept the present reality which is not all that pretty. The housing bubble, which was created by an incompetent government and fueled by Wall Street greed, has led to hundreds of bank failures, real unemployment near 17%, and many cities and states near bankruptcy. So, what now? We can continue to debate whether all the government involvement was prudent or even necessary (mostly not), but this will not help in positioning your portfolio to take advantage of what has been created.

Knowing how we got here, and what constitutes a bubble, is important in order to know what to look for to avoid getting caught in the next one. Most bubbles are associated with strong growth in money and credit, but this time the opposite is true. Bank lending continues to contract as banks are very happy to maintain large cash reserves. With near-zero interest rates, the government is forcing money out of safer investments paying near nothing into riskier investments. Why would they do this? Because when we collectively decide not to take risks the economy grin to a halt. Our government, through the Fed, has adopted a strategy of making it so uncomfortable to play it safe that investors will move into riskier assets in order to obtain the returns that they need. Unfortunately, by doing this they increase the risk of fueling speculation somewhere else and creating a new bubble – especially with the Fed making it clear that rates will stay down for “an extended period.” Ultimately, the piper will need to get paid—this will lead to much higher interest rates and a drastic reduction in value of US Treasuries somewhere down the line.

Worldwide, the extreme policy actions of the past couple of years are creating all kinds of distortions. These pressures could be alleviated by a tightening in monetary conditions in China and other growing economies that are coming out of the recession in better shape. However, they currently have very little incentive to back off the throttle on their growth engine as they attempt to provide their citizens a greater standard of living. The seeds of prosperity that used to be the domain of the USA now have a passport full of overseas destinations.

Going forward, we believe this recovery will be meek. The Fed will be tolerant of further gains in all asset prices as long as inflation expectations are calm and US economic growth remains near zero. With such a weak recovery, we do not expect the Fed to raise rates until 2011. Early last year we stated our preference of corporate bonds to stocks for 2009, and we weighted portfolios quite heavily that direction. Despite what turned out to be a decent year for the stock market, the bond positions did substantially better for the year, some even doubling the stock market. We continue to see value in corporate bonds, several foreign markets and technology stocks. While not as cheap as they were a year ago, they still offer good yields or the prospect of further growth during 2010. As always, we are monitoring the changing economic landscape and will strategically adjust your portfolio as warranted.